QUALIFIED PERSONAL RESIDENCE TRUSTS

A special kind of irrevocable trust can be used to transfer
your residence to your children at a significantly reduced
gift tax cost and with no estate tax, yet allow you to continue
to live in the residence for as long as you wish. This special
type of trust is known as a qualified personal residence
trust (QPRT). (QPRTs are sometimes also referred to as “residence
GRITs” or “house GRITs”.) Here's how it
works.

During your lifetime, you transfer your residence to
the trustee, who (if state law permits) can be yourself.
The trustee must allow you to continue to use the residence
rent-free for a fixed number of years specified in the
trust instrument (the “fixed term”), which
should be a term you are likely to survive. During the
fixed term, you will continue to pay mortgage expenses,
real estate taxes, insurance, and expenses for maintenance
and repairs, and will continue to deduct mortgage interest
and real estate taxes on your individual income tax return.
When the fixed term ends, the residence is distributed
to your children, or remains in further trust for them.

Even after the fixed term ends, you can continue to
use the residence in one of two ways. First, rather than
immediately distributing the residence to your children,
the residence can be retained in trust for your spouse's
lifetime, thus assuring that the residence is available
to you. Second, you can enter into a lease with your children
which will allow you to live in the residence for as long
as you wish. (If you do so, however, you must pay fair
market value rent to your children after the fixed term
ends in order to keep the residence from being subject
to estate tax on your death.)

Although your transfer of the residence to the trust
is a taxable gift, you are allowed to subtract, from the
fair market value of the residence, the value of your
right to live rent-free in the residence for the fixed
term. Thus, the amount of the taxable gift will usually
be substantially less than the fair market value of the
residence. If the amount of the gift is less than your
available exclusion from the gift tax ($1,000,000, reduced
by amounts allowed for gifts in previous years), no gift
tax will be due as a result of your gift to the trust.

If you survive the fixed term of the QPRT, the value
of the residence will not be included in your estate for
estate tax purposes. Even if you don't survive the fixed
term, the estate tax consequences will be no worse than
they would have been if you hadn't created the trust in
the first place. In other words, from a tax point of view,
there's no potential downside to a QPRT.
A QPRT is an effective way to remove a residence's value
from your estate at a greatly reduced gift tax cost

IRREVOCABLE LIFE INSURANCE TRUSTS ("ILIT")

How to make sure the life insurance benefits your family
will receive after your death avoid the federal estate tax.
This is an important issue because, once the federal estate
tax applies, the rates are high (beginning at 37% and going
up to 55%; though the top rate drops to 50% in 2002, 49%
in 2003, 48% in 2004, 47% in 2005, 46% in 2006, and 45%
in 2007, 2008, and 2009).

Insurance on your life will be included in your taxable
estate if either:

Your estate is the beneficiary of
the insurance proceeds, or

You possessed certain economic ownership
rights (“incidents of ownership”) in the
policy at your death (or within three years of your
death).

Avoiding the first situation is easy: just make sure
your estate is not designated as beneficiary of the policy.

The second rule is more complex. Clearly, if you are
the owner of the policy, the proceeds are included in
your estate regardless of who the beneficiary is. However,
simply having someone else possess legal title to the
policy will not prevent this result if you keep so-called
“incidents of ownership” in the policy. Rights
that, if held by you, will cause the proceeds to be taxed
in your estate include:

the right
to change beneficiaries,

the right
to assign the policy (or to revoke an assignment),

the right
to pledge the policy as security for a loan,

the right
to borrow against the policy's cash surrender value,
and

the right
to surrender or cancel the policy

Keep in mind that merely having any of the above powers
will cause the proceeds to be taxed in your estate even
if you never exercise the power.

Buy-sell agreements - Life insurance
obtained to fund a buy-sell agreement for a business interest
under a “cross-purchase” arrangement will
not be taxed in your estate (unless the estate is named
as beneficiary). For example, say Al and Bob are partners
who agree that the partnership interest of the first of
them to die will be bought by the surviving partner. To
fund these obligations, Al buys a life insurance policy
on Bob's life. Al pays all the premiums, retains all incidents
of ownership, and names himself beneficiary. Bob does
the same regarding Al. When the first partner dies, the
insurance proceeds are not taxed in his estate.

Life insurance trusts - A life insurance
trust is an effective vehicle that can be set up to keep
life insurance proceeds from being taxed in the insured's
estate. Typically, the policy is transferred to the trust
along with assets that can be used to pay future premiums.
Alternatively, the trust buys the insurance itself with
funds contributed by the insured. As long as the trust
agreement gives the insured none of the ownership rights
described above, the proceeds will not be included in
his estate.

The three-year rule - If you are considering
setting up a life insurance trust with a policy you own
currently or simply assigning away your ownership rights
in such a policy, please call me as soon as you reasonably
can to effect these moves. Unless you live for at least
three years after these steps are taken, the proceeds
will be taxed in your estate. For policies in which you
never held incidents of ownership, the three-year rule
doesn't apply.